The returns from bond markets illustrate the strength of ‘risk-off’ sentiment in financial markets. Investors have sought two things, liquidity and quality, as the chart of the average return of funds in eachsector shows, with government bonds making a positive return but negative returns in investment grade credit and more so in the High Yield space. Strategic Bond funds are ‘go anywhere’ funds that generally have a heavy bias to corporate rather than government bonds.
It is difficult to think of investing in Government Bonds with rates so low. There is minimal income and they struggle to play their traditional role as a hedge to equities in investor portfolios. However, even at this level there is a chance of a small capital gain (with negative yields, as in German Bunds for the last year) and such is the game-changing effects of the pandemic that rates are likely to stay anchored at super-low level for years to come. The massive borrowing needed to fund the fiscal support is not going to be financed by pension funds and insurance companies but by Central Banks through their bond buying programmes. There will be the usual argument that in time this will lead to inflation but this is unlikely to happen, at least for many years. Lower, for ever longer, remains the narrative.
We see better opportunities in the credit markets, though you need to sup this particular devil with a long spoon. The credit market (corporate bonds) are valued on their relationship to ‘risk free’ government bonds, the so-called ‘spreads’. At the beginning of the year the average global investment grade spread was around 100bps (1%) meaning that you got paid this premium for taking the risk of the company defaulting. The spread is currently around 280 bps, a massive move to a very large premium. Even more starkly the spread on the lower quality High Yield bonds has jumped by 600bps (6%) to around a 10% spread. Yields are thus very attractive, the caveat being risk of default with income distributions being cancelled or worse, a loss of capital if the firms are bankrupted.
There is going to be a whole host of downgrades in debt quality, notably in the ‘fallen angels’ which are investment grade companies downgraded to High Yield, such as dear old Marks and Spencer. Many High Yield companies are going to find access to liquidity difficult as they burn through cash very quickly as revenues dry up completely. Outright defaults are the worst-case scenario but bankruptcies are likely to be predominantly in the lowest quality rungs of the ladder, with the US energy sector particularly vulnerable following the collapse in the oil price. One of the key features of the huge fiscal policy packages is to help otherwise healthy companies through this liquidity crisis.